House Votes Yes On Small Business Bill; Tax Court Holds Documentary Filmmaking Activity To Be Trade or Business, Not Hobby

Surprising absolutely no one, the Republican dominated House passed majority leader Eric Cantor’s tax proposal today by a 235-173 vote. The proposal, which would have given a 20% tax deduction to all businesses with fewer than 500 employees, was voted largely on party lines, with 18 Democrats voting in favor of the plan and 10 Republicans rejecting it. The plan now heads to the Democratic-controlled Senate, where it’s doomed to suffer a crushing defeat.

In other news, cheap champagne will be unscrewed in unkempt studio apartments throughout SoHo tonight, celebrating the Tax Court’s decision in Storey v. Commission, T.C. Memo 2012-115, which determined that the documentary filmmaking activity of a full-time attorney was entered into for profit, not a hobby.

In recent years, the activities of documentary filmmakers have found themselves under attack from the IRS by virtue of the “hobby loss” rules of I.R.C. § 183. While surely frustrating to the filmmakers, it’s no surprise that the IRS eventually turned their attention to documentary films. Like horse breeding and drag racing, which are already heavily litigated under the hobby loss rules, documentary filmmaking is a labor of love requiring long periods of development, with scarce profits to be found. As a result, heavy losses over a period of years are the norm, and because the basis for the films are often areas of interest to the filmmaker, elements of personal pleasure are present, strengthening the Service’s argument that the activity is in fact a hobby.

In Storey — a case the filmmaking community had been keeping its watchful, distrusting eye on, the Tax Court struck a blow for the industry by holding that a prominent lawyer who also made a successful documentary did so as a trade or business, not as a hobby.

Lee Storey was a name partner in a successful California law firm. Several years into her marriage, she discovered that her husband had formerly been a member of Up With People, the legendarily dorky group of singers whose wholesome half-time performances at Super Bowls during the ’70’s and ’80’s stand in stark contrast to the exposed nipples and middle fingers of today.

This new information about her husband’s past sparked a long-standing desire in Storey to venture into filmmaking. Up With People, she concluded, would be the perfect subject for a documentary. Storey took a sabbatical from work to study filmmaking, bought up the rights to archival Up With People footage, and started making her movie.

Storey carried on the activity in a very professional manner, hiring a bookkeeper and keeping detailed records. She attended conferences, where she networked and eventually met part of her production team. Storey used trailers and rough cuts to pitch her product, making edits based on the solicited feedback. Though she hadn’t originally planned to feature her husband in the documentary, she was encouraged to do so by her producer, and her husband eventually would up in four of the film’s 79 minutes.

In 2009, Smile ‘Til It Hurts, Storey’s film about Up With People, launched at the Slamdance Film Festival. The documentary was largely met with critical claim, though like most films in the genre, it was not profitable. Today, Storey still owns the rights to the film, and sells DVDs for $19.99 a pop.

On her 2006-2008 tax returns, Storey deducted losses from her film making activities. The IRS denied the losses, largely arguing that Storey did not make Smile ‘Til It Hurts for profit, but rather to fulfill her curiosity about her husband’s past and to tell his story.

The Tax Court disagreed. After addressing the following nine “hobby loss” regulations found at Treas. Reg. §1.183-2(a) — and discussed previously here, here, and here — the court concluded that Storey’s filmmaking activity was entered into for profit and its losses deductible in full.

As a reminder, those factors are:

(1) the manner in which the taxpayer carried on the activity,

(2) the expertise of the taxpayer or his or her advisers,

(3) the time and effort expended by the taxpayer in carrying on the activity,

(4) the expectation that the assets used in the activity may appreciate in value,

(5) the success of the taxpayer in carrying on other similar or dissimilar activities,

(6) the taxpayer’s history of income or loss with respect to the activity,

(7) the amount of occasional profits, if any, which are earned,

(8) the financial status of the taxpayer, and

(9) whether elements of personal pleasure or recreation are involved.

Aside from factors six, seven, and eight[i], it was a clean sweep for Storey. By keeping detailed books and records, seeking advice and education regarding the best way to make her movie, spending considerable time on the film making process, and generally conducting her activity in a formal, businesslike manner, Storey was able to satisfy her burden of proving that the documentary activity was in fact a trade or business. Though the court conceded that Storey did greatly enjoy filmmaking and had used her husband in the film, these elements of personal pleasure were not sufficient to classify the activity as a hobby.

[i] The film did not generate net income during the years at issue, so factors six and seven were a no-brainer. As for factor eight, the fact that losses from the film were offsetting Storey’s considerable income from her law practice weighed against her.

[…] discussed the Republican plan, which had previously and predictably passed the House in April, here. In summary, it would have provided a 20% deduction from taxable income for all business with fewer […]

The items in this blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation. A select group of Tax Professionals of WithumSmith+Brown write Double Taxation, and any opinions expressed or implied are not necessarily shared by anyone else at WithumSmith+Brown.

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